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Copyright © 2010 Pearson Prentice Hall. All rights reserved. 1-1

The Multinational Enterprise (MNE)

� A multinational enterprise (MNE) is definedas one that has operating subsidiaries,branches or affiliates located in foreign

countries.� The ownership of some MNEs is so

dispersed internationally that they areknown as transnational corporations.

� The transnationals are usually managedfrom a global perspective rather than fromthe perspective of any single country.

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Multinational Business Finance

� While multinational business finance emphasizesMNEs, purely domestic firms also often havesignificant international activities:

± Import & export of products, components and services± Licensing of foreign firms to conduct their foreign

business

± Exposure to foreign competition in the domestic market

± Indirect exposure to international risks through

relationships with customers and suppliers

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Globalization and Creating Value in theMultinational Enterprise

� Global business, like any business, is the socialscience of managing people to organize, maintainand grow the collective productivity towardaccomplishing productive goals, typically to

generate profit and value for its owners andstakeholders.

� Reaching that goal requires combining threecritical elements:± An open marketplace

± High quality strategic management

± Access to capital

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Exhibit 1.1 Creating Firm Value in GlobalMarkets

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The Theoryof Comparative Advantage

� The theory of comparative advantage provides a basisfor explaining and justifying international trade in amodel world assumed to enjoy:

± free trade;

± perfect competition;

± no uncertainty;

± costless information, and

± no government interference.

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� The theory contains the following features:

± Exporters in Country A sell goods or services to unrelatedimporters in Country B

± Firms in Country A specialize in making products that canbe produced relatively efficiently, given Country A¶sendowment of factors of production, that is, land, labor,capital, and technology

± Firms in Country B do likewise, given the factors of

production found in Country B± In this way the total combined output of A and B is

maximized

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± Because the factors of production cannot be moved freelyfrom Country A to Country B, the benefits of specialization are realized through international trade

± The way the benefits of the extra production are shareddepends on the terms of trade, the ratio at which

quantities of the physical goods are traded± Each country¶s share is determined by supply and

demand in perfectly competitive markets in the twocountries

± Neither Country A nor Country B is worse off than beforetrade, and typically both are better off, albeit perhaps

unequally

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� Although international trade might haveapproached the comparative advantage modelduring the nineteenth century, it certainly does

not today, for the following reasons:± Countries do not appear to specialize only in those

products that could be most efficiently produced by thatcountry¶s particular factors of production (as a result of government interference and ulterior motivations)

± At least two factors of production ± capital andtechnology ± now flow directly and easily betweencountries

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± Modern factors of production are more numerous than inthis simple model

± Although the terms of trade are ultimately determined bysupply and demand, the process by which the terms are

set is different from that visualized in traditional tradetheory

± Comparative advantage shifts over time, as lessdeveloped countries become developed and realize theirlatent opportunities

± The classical model of comparative advantage did notreally address certain other issues, such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitivemarkets, and economies of scale

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� Comparative advantage is however still a relevant theory toexplain why particular countries are most suitable for exportsof goods and services that support the global supply chain of both MNEs and domestic firms.

� The comparative advantage of the 21st century, however, isone based more on services, and their cross-borderfacilitation by telecommunications and the Internet.

� The source of a nations comparative advantage is stillcreated from the mixture of its own labor skills, access to

capital, and technology.

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Exhibit 1.2 Global Outsourcing of Comparative Advantage

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Market Imperfections: ARationale for the Existence of the

Multinational Firm� MNEs strive to take advantage of imperfections in

national markets for products, factors of production, and financial assets.

� Imperfections in the market for products translateinto market opportunities for MNEs.

� Large international firms are better able to exploitsuch competitive factors as economies of scale,

managerial and technological expertise, productdifferentiation, and financial strength than aretheir local competitors.

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Market Imperfections: ARationale for the Existence of the

Multinational Firm� Strategic motives drive the decision to invest

abroad and become a MNE and can besummarized under the following categories:

± Market seekers

± Raw material seekers

± Production efficiency seekers

± Knowledge seekers

± Political safety seekers

� These categories are not mutually exclusive.

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Sustaining and TransferringCompetitive Advantage

� In industries characterized by worldwideoligopolistic competition, each of the abovestrategic motives should be subdivided into

proactive and defensive investments.� Proactive investments are designed to

enhance the growth and profitability of thefirm itself.

� Defensive investments are designed todeny growth and profitability to the firm¶scompetitors.

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Exhibit 1.3 What Is Different aboutInternational Financial

Management?

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Who Owns the Business?

� Most companies are created byentrepreneurs who are either individuals ora small set of partners.

� In either case they may be the members of a family.

� Over time, however, some firms maychoose to go public via an initial publicoffering or IPO.

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Exhibit 2.1 Who Owns the Business?

[Insert Exhibit 2.1]

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Separation of Ownership fromManagement

� The change in ownership from 100%privately held toward an increased share of publicly traded shares brings along with it

the probability that a firm may be managedby hired professionals and not the owners.

� This raises the possibility that ownershipand management may not be perfectly

aligned in their business and financialobjectives, the so called agency problem.

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The Goal of Management

� Maximization of shareholders¶ wealth is thedominant goal of management in theAnglo-American world.

� In the rest of the world, this perspectivestill holds true (although to a lesser extentin some countries).

� In Anglo-American markets, this goal isrealistic; in many other countries it is not.

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The Goal of Management

� There are basic differences in corporateand investor philosophies globally.

� In this context, the universal truths of finance become culturally determined norms.

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Shareholder Wealth Maximization

� In a Shareholder Wealth Maximizationmodel (SWM), a firm should strive tomaximize the return to shareholders, as

measured by the sum of capital gains anddividends, for a given level of risk.

� Alternatively, the firm should minimize thelevel of risk to shareholders for a given

rate of return.

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� The SWM model assumes as a universaltruth that the stock market is efficient.

� An equity share price is always correct

because it captures all the expectations of return and risk as perceived by investors,quickly incorporating new information intothe share price.

� Share prices are, in turn, the bestallocators of capital in the macro economy.

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� The SWM model also treats its definition of risk asa universal truth.

� Risk is defined as the added risk that a firm¶sshares bring to a diversified portfolio.

� Therefore the unsystematic, or operational risk,should not be of concern to investors (unlessbankruptcy becomes a concern) because it can bediversified.

� Systematic, or market, risk cannot however beeliminated.

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� Agency theory is the study of how shareholders can motivatemanagement to accept the prescriptions of the SWM model.

� Liberal use of stock options should encourage managementto think more like shareholders.

� If management deviates too extensively from SWMobjectives, the board of directors should replace them.

� If the board of directors is too weak (or not at ³arms-length´) the discipline of the capital markets could effect thesame outcome through a takeover.

� This outcome is made more possible in Anglo-Americanmarkets due to the one-share one-vote rule.

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� Long-term value maximization can conflict withshort-term value maximization as a result of compensation systems focused on quarterly ornear-term results.

� Short-term actions taken by management that aredestructive over the long-term have been labeledimpatient capitalism.

� This point of debate is often referred to a firm¶sinvestment horizon (how long it takes for a firm¶sactions, investments and operations to result in

earnings).

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� In contrast to impatient capitalism is patient capitalism.

� This focuses on long-term SWM.

� Many investors, such as Warren Buffet,have focused on mainstream firms thatgrow slowly and steadily, rather thanlatching on to high-growth but riskysectors.

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Stakeholder Capitalism Model

� In the non-Anglo-American markets,controlling shareholders also strive tomaximize long-term returns to equity.

� However, they are more constrained by otherpowerful stakeholders.

� In particular, labor unions are more powerfulthan in the Anglo-American markets.

� In addition, Governments interfere more in the

marketplace to protect important stakeholdergroups, such as local communities, theenvironment and employment.

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� The SCM model does not assume that equitymarkets are either efficient or inefficient.

� The inefficiency does not really matter, because

the firm¶s financial goals are not exclusivelyshareholder-oriented, because they areconstrained by the other stake-holders.

� The SCM model assumes that long-term ³loyal´ shareholders ± those typically with controlling

interests ± should influence corporate strategy,rather than the transient portfolio investor.

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� The SCM model assumes that total risk ± i.e.operating and financial risk ± does count.

� It is a specific corporate objective to generate

growing earnings and dividends over the long runwith as much certainty as possible.

� In this case, risk is measured more by productmarket variability than by short-term variation inearnings and share price.

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Operational Goals for MNEs

� The MNE must determine for itself proper balancebetween three common operational financialobjectives:

± maximization of consolidated after-tax income;

± minimization of the firm¶s effective global tax burden;

± correct positioning of the firm¶s income, cash flows, andavailable funds as to country and currency.

� These goals are frequently incompatible, in that

the pursuit of one may result in a less-desirableoutcome in regard to another.

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Corporate Governance

� Although the governance structure of anycompany ± domestic, international, ormultinational ± is fundamental to its very

existence, this subject has become alightning rod for political and businessdebate in the past few years.

� Spectacular failures in corporategovernance have raised issues about thevery ethics and culture of the conduct of business.

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� The single overriding objective of corporategovernance is the optimization over time of the returns to shareholders.

� In order to achieve this goal, goodgovernance practices should focus theattention of the board of directors of the

corporation by developing andimplementing a strategy that ensurescorporate growth and improvement in thevalue of the corporation¶s equity.

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� The most widely accepted statement of goodcorporate governance practices are establishedby the OECD:± The corporate governance framework should protect

shareholders rights.± The corporate governance framework should ensurethe equitable treatment of all shareholders.

± Stakeholders should be involved in corporategovernance.

± Disclosure and transparency is critical.

± The board of directors should be monitored and heldaccountable for what guidance it gives.

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Structure of Corporate Governance

� The modern corporation¶s actions and behaviorsare directed and controlled by both internal forcesand external forces.

� The internal forces, the officers of the corporation

and the board of directors are those directlyresponsible for determining both the strategicdirection and the execution of the company¶sfuture.

� The external forces include equity markets inwhich the shares are traded, the analysts who

critique the company¶s investment prospects andexternal regulators, among others.

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Exhibit 2.2 The Structure of CorporateGovernance

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Structure of Corporate Governance

� Equity markets should reflect the market¶s constantevaluation of the promise and performance of the company.

� Debt markets should reflect the company¶s ability to repayits debt in a timely and efficient manner.

� Auditors and legal advisors are responsible for providing an

external professional opinion as to the fairness, legality andaccuracy of corporate financial statements.� Regulators work to ensure, among other things, that a

regular and orderly disclosure process of corporateperformance is conducted so that investors may evaluate acompany¶s investment value with accuracy

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Exhibit 2.3 Comparative CorporateGovernance Regimes

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Failures in Corporate Governance

� Failures in corporate governance have become increasinglyvisible in recent years.

� In each case, prestigious auditing firms missed the violationsor minimized them, presumably because of lucrative

consulting relationships or other conflicts of interest.� In addition, security analysts urged investors to buy the

shares of firms they knew to be highly risky (or even close tobankruptcy).

� Top executives themselves were responsible for

mismanagement and still received overly generouscompensation while destroying their firms.

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Corporate Governance Reform

Within the United States and the United Kingdom, the maincorporate governance problem is the one treated by agencytheory: with widespread share ownership, how can a firm alignmanagement¶s interest with that of the shareholders?

Because individual shareholders do not have the resources or the power to monitor management, the U.S. and U.K. markets rely onregulators to assist in the agency theory monitoring task.Outside the U.S. and U.K., large, controlling shareholders are inthe majority ± these entities are able to monitor management insome ways better than the regulators can.

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The Sarbanes-Oxley Act

� This act was passed by the US Congress, and signed byPresident George W. Bush during 2002 and has threemajor requirements:± CEOs of publicly traded companies must vouch for the

veracity of published financial statements;± corporate boards must have audit committees drawn from

independent directors;± companies can no longer make loans to corporate directors,

and± Companies must test their internal financial controls against

fraud

� Penalties have been spelled out for various levels of failure.

� Most of its terms are appropriate for the US situation, butsome terms do conflict with practices in other countries.

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Additional Corporate GovernanceIssues

� Board structure and compensation issues

� Transparency, accounting and auditing

� Minority shareholder rights

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Mini-Case Questions: GovernanceFailure at Enron

� Which parts of the corporate governance system, internaland external, do you believe failed Enron the most?

� How do you think each of the individual stakeholders andcomponents of the corporate governance system shouldhave either prevented the problems at Enron or acted to

resolve the problems before they reached crisisproportions?� If all publicly traded firms in the United States are

operating within the same basic corporate governancesystem as Enron, why would some people believe thiswas an isolated incident, and not an example of manyfailures to come?

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